A Better Way to Double Your Returns

Lately, everyone seems to be in a hurry to earn back the money they lost last year as quickly as possible. That's created a perfect environment for companies offering leveraged exchange-traded funds, which promise amplified returns from market movements in either direction.

But if you're looking for the kind of leverage that lets you truly multiply your long-term returns, then those ETFs aren't the way to go. Instead, there's a better strategy involving options. It'll give you at least a chance of making some serious money, if you pick the right stocks.

Why leveraged ETFs didn't workThe reason leveraged ETFs have gotten so much attention lately, from warnings from financial regulators to outright bans at some brokers, is that they don't work when you hold them over multiple trading sessions. Typically, these ETFs are designed to track indexes on a daily basis.

The problem, though, is that they don't track those same indexes for longer periods of time. As a result, sometimes both the bullish and bearish ETFs tied to the same index produce substantial losses for ETF shareholders. Just take a look at some examples:

Sector

2-Year Total Return of Bull Fund

2-Year Total Return of Bear Fund

Oil

(61.7%)

(60.7%)

Financial Stocks

(87.1%)

(73.8%)

Real Estate

(81.4%)

(91.7%)

Source: Yahoo! Finance as of Dec. 3.

You'd think that either bulls or bears would've made money. Yet with these ETFs, it didn't matter which way you bet -- if you held onto these funds all year, you lost money.

Know your investmentIf you want leverage for a longer period than a single day, you need to pick an investment that's better-suited to that purpose. One way would be to buy stock on margin, but that has its own dangers. However, there's an alternative using options that's quite a bit safer.

Say you want to use double leverage over a period of several months. One easy method to get that leverage is to buy deep in-the-money call options that cost about half what you'd pay for the company's stock. If you do that, you can buy options on 200 shares with the same money you'd pay for 100 shares outright. That doubles your risk -- and reward.

Here are some examples of how this options strategy can work in real life:

Source: CBOE.Options expire in 2010 unless otherwise noted, and prices are based on bid-ask spreads as of Dec. 7.

For more detail, look at General Electric. To buy 100 shares, you'd spend $1,620. Or you could buy call options on 200 shares for $1,540. If you bought the stock and it rose to $25 by mid-March, your shares would be worth $2,500, for a profit of $880. On the other hand, the options would be worth $17 per share, or $3,400, for a profit of $1,860 -- almost twice the profit from buying the stock, just as you intended.

Of course, if the stock price falls, you'll lose twice as much money. But that's the downside of using leverage.

Moreover, because options let you choose different expiration dates, you get to decide the length of time you want to measure your returns. Unlike leveraged ETFs, you're not stuck with the one-day timeframe. Now, because options have time value, you may have to pay extra for longer-dated options, but once you do, you never have to worry about the tracking errors that leveraged ETFs face.

Leverage is optionalOptions open a number of interesting doors for investors, but not all of them involve any leverage whatsoever. Used wisely, they can be valuable tools to help you enhance your returns to generate extra income and attain better buying and selling prices -- just to name a couple.

In fact, Motley Fool CFO Ollen Douglass recently made more than $100,000 with a simple options strategy involving six well-known stocks, and he's looking to our Motley Fool Options service for real-money advice on what to do with his profits. To learn more about Ollen's story and find out more about options, just enter your email address in the box below to get the latest information.

This article was originally published Aug. 12, 2009. It has been updated.

Fool contributor Dan Caplinger typically avoids leverage, but he's been known to buy an option or two here and there. He owns shares of General Electric.3M and Wal-Mart are Motley Fool Inside Value recommendations. Johnson & Johnson is an Income Investor selection.The Fool's disclosure policy gives you all the options.

Comments from our Foolish Readers

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One thing about options like these is that the historical prices are sometimes out of line with the most current stock price. That's what happened with some of the quotes in this chart.

You're absolutely right that if you could buy a call option for less than the current stock price less the strike price, it'd always make sense to do so. In practice, though, the most up-to-date option prices will likely never give you that opportunity when compared to the most up-to-date stock price.

One thing about options like this is that the historical prices don't always reflect the current value of the shares. That's what happened here with GE and Wal-Mart.

You're right that if you can buy a call for less than the difference between the stock price and the option strike price, then you'd have an automatic profit. In practice, though, you'll find that's never the case if you're comparing the most up-to-date stock price with the most up-to-date options prices from the options exchanges.

I understand that. What I don't understand is: Why, in a thoughtful article, you would print data that are clearly inaccurate and then base an analysis on that faulty data. You highlight your article using the GE example which is one of the flawed data lines..